What is the working capital?
The working capital of a company is the funding requirement (or cash surplus) arising mainly from the temporal differences between the production cycle and the payment cycle.
How to compute the working capital?
The working capital can be calculated from the balance sheet by adding the short term non-financial assets (inventory, accounts receivables, etc.) and subtracting the short term non-financial liabilities (accounts payables, social and fiscal debts, etc.) of the company.
For example if the company has:
- £1,000 worth of inventory
- £5,000 worth of accounts receivables
- £3,000 worth of accounts payables
Then its WC is 1,000 + 5,000 - 3,000 = £3,000.
What is the impact of the working capital on the company's cash flow?
When the working capital is positive (like in the example above), it represents a funding requirement for the company. And when it is negative, the WC constitutes a cash surplus.
One of the particularities of the working capital is that it is temporary: it arises because of timing mismatches and disappears when these get regularised.
Let's take another example. A company produces goods in early January, keep them in inventory, and then sells them in February with a 30 days payment term. The goods sold in February will therefore be paid in March. In the meantime the company had to pay its employees in January and February, and the suppliers from whom it bought the raw materials to manufacture the goods. As you can see, the company needs to have a sufficient amount of cash to cover for the temporal difference between the day it starts manufacturing the goods and the day it gets paid from its client.
Another specificity of the working capital is that it is relative: it is proportional to the level of activity.
Example: the company always keeps the equivalent of 1 month of sales as inventory, gets paid 30 days after making the sale, and benefits from a 20 days payment term from its suppliers.
If the company increases its sales, the value of the inventory and the difference between the amount it owes and the amount it is owed will also increase.
Because it is both temporary and relative, the working capital needs to be analysed by following the evolution of a few ratios in time.
Inventory x 365 / Revenues:
This ratio assesses how many days of sales are kept in inventory, and allows to track the company's efficiency in terms of inventory management.
Accounts receivables x 365 / Revenues:
This ratio tracks how long it takes for the company to get paid by its clients.
Accounts payables x 365 / Cost of goods sold :
This ratio tracks the payment terms agreed with the suppliers.
WC / Revenues:
If the previous 3 ratios are stable, this ratio enables the financial analyst to quickly assess the value of the working capital going forward.
For example, if a company as a WC / Revenues ratio of 16% and anticipates to grow its revenues by £1m next year. The growth will translate into a working capital increase of 16% x £1m = £160k.